“Goodwill Valuation”

Goodwill – The most intangible of all Assets Reflects the fact that an ongoing business had some "prudent value" beyond its assets In accounting it is the excess cost required to acquire the business over the fair market value of all other assets. Can be sold only with the business and appears as an asset on the balance sheet of the acquiring firm Goodwill = Selling price as a going concern – Fair value of separate net assets Goodwill = Selling price – (Assets – Liabilities)

Why does the Buyer Pay?? Buyer may be willing to pay more for a business as a going concern because of: Strong Brand Name Good customer relations Good reputation Well-known products Patents or Proprietary Technology Experienced and efficient employees and management team Good relation with suppliers

Types of Goodwill Inherent Goodwill Goodwill generated internally Its should not be recognized as an assets. Inherent goodwill is only an estimation. Therefore, it should not be brought into the books, and no accounting entry is required. It constitutes of internally generated brands, publishing titles, customer list, and items in similar substance Purchased Goodwill (Enterprise Level Goodwill) Generated during the acquisition of a business It is the difference between the selling price of a business as a going concern and the total value of its separable net assets Some companies may write it off immediately against reserves, or amortized through the profit and loss account over its useful economic life Evaluated using market-value method

Accounting of Goodwill 1. Original Balance Sheet 4. Goodwill = P - FV identifiable net assets 3. Consideration paid = $400: new CSE 2. Fair values of identifiable assets Entry: Cash ........................ 25 AR ........................... 35 Inventory ................. 122 PPE .......................... 205 Patents ..................... 18 Goodwill ................. 50 CL ............................ 55 Cash ......................... 400 5

Goodwill –Negative “Badwill” or Bargain purchase Fair value of acquired assets is greater than the purchase price Record as an extra ordinary gain Negative goodwill is recognized as a gain to the extent that it exceeds allocations to certain assets. It is recognized in the income statement when the future losses and expenses are recognized. If any excess remains after such assignment, remainder treated as an extraordinary gain into the books, and no accounting entry is required 6 6

GOODWILL It is most widely known all persuasive intangible asset that arises on acquisition or generated internally. Internally generated goodwill is dealt with by AS -26 Goodwill generated on acquisition is governed by AS 10.

GOODWILL...AS10 Goodwill, in general, is recorded in the books only when some consideration in money or money’s worth has been paid for it. Whenever a business is acquired for a price (payable either in cash or in shares or otherwise) which is in excess of the value of the net assets of the business taken over, the excess is termed as ‘goodwill’. Goodwill arises from business connections, trade name or reputation of an enterprise, Brand value or from other intangible benefits enjoyed by an enterprise. As a matter of financial prudence, goodwill is written off over a period. However, many enterprises do not write off goodwill and retain it as an asset.

Brand Equity …An Intangible asset It is the value addition provided to a product or a company by its Brand Name . It is a financial premium that a buyer is willing to pay for the brand over a generic or less worthy brand .

How to Measure ? Brand Earnings Multiple model is most widely used to measure the brand equity. Steps : Determine brand profits by eliminating the non brand profits from the total profits Restate the historical profits at present day values. Provide for the remuneration of capital to be used for purposes other than promotions of the brand . Adjust for the taxes. Determine the brand strength or brand earning multiple.

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AS 26 The objective of this Statement is to prescribe the accounting treatment for intangible assets that are not dealt with specifically in another Accounting Standard. This Statement requires an enterprise to recognise an intangible asset if, and only if, certain criteria are met. Internally generated goodwill is dealt by AS 26

The key conditions are that: The asset should be identifiable The definition of an intangible asset requires that an intangible asset be identifiable. To be identifiable, it is necessary that the intangible asset is clearly distinguished from goodwill. Goodwill arising on an amalgamation in the nature of purchase presents a payment made by the acquirer in anticipation of future economic benefits. The future economic benefits may result from synergy between the identifiable assets acquired or from assets which, individually, do not qualify for recognition in the financial statements but for which the acquirer is prepared to make a payment in the amalgamation.

2) The asset should be separable An intangible asset can be clearly distinguished from goodwill if the asset is separable. An asset is separable if the enterprise could rent, sell, exchange or distribute the specific future economic benefits attributable to the asset without also disposing of future economic benefits that flow from other assets used in the same revenue earning activity.

Accounting for Goodwill in Partnership Only purchased goodwill is to be brought into the accounts. In sole trader’s accounts, goodwill is to be recognized and recorded in the books only if the business is acquired as a going concern In partnerships, however, goodwill is brought into the books whenever there is a change in the partnership such as: Admission of a new partner Retirement of an old partner Change of the profit-sharing ratio Each partner has a share of the profit-sharing ratio. At a change in the partnership, goodwill must be taken into account and shared among the existing partners, according to the existing profit-sharing ratio

Valuation of Goodwill Subjective Judgment (Mainly applicable for Partnership firms) Estimate the value of goodwill with reference to some intangible factors and according to their professional judgment Average Sales/Fees/Profits Method Under this method goodwill is calculated on the basis of the average of some agreed number of past years. The average is then multiplied by the agreed number of years. Goodwill = Average Profits x Number of years of Purchase The following adjustments should be made in the profits of the firm: a. Any abnormal profits should be deducted from the net profits of that year. b. Any abnormal loss should be added back to the net profits of that year. c. Non operating incomes ex. income from investments  etc. should be deducted from the net profits of that year.

Average Sales Method Year Annual Sales 1995 100000 1996 200000 1995 100000 1996 200000 1997 300000 Goodwill is valued at 3 years’ purchase of the average annual sales of the past 3 years: Average annual sales = ($100000+200000+300000 ) /3 = $200000 Goodwill = $200000 X 3 = $600000

Average Sales Method – Weighted Approach Annual net profits for 2005 to 2008 were $25,000, $40,000, $75,000 and $60,000 respectively. 25,000 x 1 + 40,000 x 2 + 75,000 x 3 + 60,000 x 4 1 + 2 + 3 + 4 = 57,000

Goodwill – Super Profits Method No of Years Purchased Method - Goodwill is calculated on the basis of Super Profits i.e. the excess of actual profits over the average profits. Example if the normal rate of return in a particular type of business is 20% and your investment in the business is Rs.10,00,000 then your normal profits should be Rs.2,00,000. But if you earned a net profit of Rs. 2,30,000 then Rs.2,30,000 - Rs.2,00,000= Rs.30,000 are your super profits. For calculating Goodwill Super Profits are multiplied by the number of years of purchase. Normal Profits = Capital Invested X Normal rate of return/100 Super Profits = Actual Profits - Normal Profits Goodwill = Super Profits x No. of years purchased

Super Profits Method.. Cont.… Sliding scale method: This valuation is based on a more realistic assumption that super profits would decline over a period of time and after a certain period they would all together disappear. Amount of super profits Number of years 1000 4 1500 3 2000 2 3000 1 Goodwill = 1000*4+1500*3+2000*2+3000*1 = 15500

Super Profits Method.. Cont.… Annuity method: This method takes into consideration the time value of money. Based on the assumption that payment for goodwill is made on the basis of super profits which are to be earned in future. Hence present value of super profits is computed to calculate the goodwill. It requires expected rate of interest should be used to discount the future super profits. Goodwill = Super Profits p.a * relevant annuity value

Super Profits Method.. Example Chan is leaving the partnership, and goodwill is to be revalued at 3 years’ purchase of the super profit. The expected rate of return on net tangible assets is 10 %, after paying a management fee of $500. The calculation of the super profit is to be based on the average profits of the last four years. Net Tangible Assets are $50,000 Net profit from 1994-1997 is $5000, $6500, $6500, $7000 Expected return on net tangible assets = Net tangible assets * 10%. Expected return is $5000.

Solution Average net profit (5000+6500+6500+7000) / 4 6250 (5000+6500+6500+7000) / 4 6250 Management fee 500 Expected rate of return on net tangible assets 5000 5500 Super profit 750 Goodwill = $750 x 3 = $2250

Goodwill - Capitalization Method Capitalization of Average Profits Method: We calculate the average profits and then assess the capital needed for earning such average profits on the basis of normal rate of return. Such capital is called capitalized value of average profits. The formula is:- Capitalized Value of Average Profits = Average Profits X (100 / Normal Rate of Return) Capital Employed = Assets - Liabilities Goodwill = Capitalized Value of Average Profits - Capital Employed Capitalization of Super Profits: Under this method first of all we calculate the Super Profits and then calculate the capital needed for earning such super profits on the basis of normal rate of return. This Capital is the value of our Goodwill . The formula is:- Goodwill = Super Profits X (100/ Normal Rate of Return)

Goodwill on Admission of New Partner Chan and Wong were partners sharing profits and losses equally. On 1 January 2009, they admitted Lee as a new partner who was required to introduce $600 as capital. The profits are now to be shared among Chan, Wong and Lee equally. Goodwill is valued at $300. The balance sheet before the admission of the new partner is shown as follows: Chan and Wong as at 31 December 2009 Assets 1,200 Capital Chan 600 Wong 600 1,200 1,200

Goodwill Account Opened Capital: Chan (1/2) 150 Wong (1/2) 150 Balance C/F 300 300 300 Capital Chan Wong Lee Chan Wong Lee Balance B/F 600 600 Balance c/f 750 750 600 Goodwill 150 150 Cash 600 750 750 600 750 750 600

Goodwill Account opened Balance Sheet Assets Capital Goodwill 300 Chan 750 Other Assets (1,200 + 600) 1,800 Wong 750 Lee 600 New capital balance 2,100 2,100

Goodwill on a change in the profit-sharing ratio When there is a change in the profit-sharing ratio, the value of goodwill should also be re-assessed, so as to ascertain the amount of resources a partner has to give up ( in terms of a reduction in the relative capital balance) for the gain in his share of profits/loss. Example Yip, Chow and Au are partners in a trading firm and share profits and losses in the ratio 3:3:2. On 31 December 2009, they wanted to change the profit-sharing ratio to 1:1:1. The goodwill is revalued at $9,000. The firm’s balance sheet on 31 December 2009 was: Balance Sheet as at 31 December 2009 Goodwill 1,000 Capital: Yip 30,000 Other Assets 79,000 Chow 30,000 Au 20,000 80,000 80,000

Goodwill account opened Balance B/F 1,000 Balance c/f 9,000 Capital: Yip (3/8) 3,000 Chow (3/8) 3,000 Au (2/8) 2,000 8,000 9,000 9,000 Capital Yip Chow Au Yip Chow Au Balance b/f 30,000 30,000 20,000 Balance c/f 33,000 33,000 22,000 Goodwill 3,000 3,000 2,000 33,000 33,000 22,000 33,000 33,000 22,000

Goodwill account opened Balance Sheet as at 31 December 2010 Goodwill 9,000 Capital Other Assets 79,000 Yip 33,000 Chow 33,000 Au 22,000 88,000 88,000